Fears of an economic disaster are driving valuations of many dividend-yielding companies to outrageous levels relative to the overall market historically, according to Dom Grestoni, head of North American equities at Winnipeg-based IG Investment Management Ltd., the money management arm of Investors Group.

“Investors are paying 20-plus times earnings for boring, but consistently dependable pipeline companies that barely grow better than GDP over the longer term,” he said. “Yet banks that provide significantly higher yields are being shunned because of perceived market risks.”

He notes Canadian banks are showing very good growth, boosting dividends and reporting exceptional earnings, despite having to raise large amounts of new capital.

“They are providing yields of 4% to 5%, but because the market is concerned, they are trading at 9-10x estimated earnings, while Enbridge is at 23x,” Grestoni said.
Grestoni points out that companies such as Canadian Utilities Ltd., Enbridge Inc. and Fortis Inc. are being priced as if they are going to outgrow the likes of Apple Inc.

At the same time, many investors are shunning a variety of high-quality equities that provide dividend yields substantially higher than long-term bonds, as well as modest dividend growth of 3% to 5% per year.

The manager of the Investors Dividend Fund, one of the largest mutual funds in Canada, considers many of these equities to be value plays since they are trading below current market multiples.

He sees opportunity in Canadian commodity producers as well. Even though investors fear that China’s slowing GDP growth rate will hurt demand for things such as copper, oil and coal, he notes that the country’s previous 10%-plus growth was based on a $2-to-$3-trillion economy, not today’s $6-trillion base.

Grestoni is also reducing his exposure to defensive sectors such as telecoms, utilities, health care and pipelines and focusing on pure-play energy companies like Suncor Energy Inc. and Canadian Natural Resources Ltd., as well as others that should benefit from a continued economic cyclical expansion.

BUYS

Royal Bank of Canada (RY/TSX)

The position: Roughly 10% of fund

Why do you like it? Grestoni owns four Canadian banks, but his current favourite is Royal Bank. He believes the setback in its share price over the past year, due to weakness in their U.S. operations and greater reliance on capital markets, was overblown. “We’re happy to see the dividend increase, stability return to various operations and the outstanding performance from retail banking in Canada,” he said.

Biggest risk: If the bank becomes overly aggressive in its capital market businesses, which are producing lower returns than retail banking

Sun Life Financial Inc. (SLF/TSX)

The position: Roughly 2% of fund

Why do you like it? After paring back his exposure to Sun Life over the past two years, Grestoni thinks the company’s prospects are improving. “They’ve restructured their U.S. business, they’ve consolidated their North American money-management operations, and they’ve done some actuarial assumption changes that have partly cleansed their book,” he said.

Biggest risk: A sustained low interest rate environment

Telus Corp. (T.A/TSX)

The position: Roughly 7% of fund

Why do you like it? Grestoni owns both Telus’ voting and non-voting shares, but favours the latter because they provide the same dividend and claim to earnings at a lower price — therefore a higher yield. Telus has proposed to convert all its non-voting shares to voting shares on a one-for-one basis.

Biggest risks: The competitive environment; expansion into non-traditional capital-intensive businesses such as IPTV

SELL

Canadian Utilities Ltd. (CU/TSX)

The position: Trimmed exposure by roughly 50% in recent months

Why don’t you like it? Grestoni likes what the company is doing, but trimmed his exposure due to its higher valuation and lower growth relative to most other sectors. “It is trading well above its long-term multiple and the yield is well below where we are comfortable holding it,” he said. “It’s got 3-4% growth and the dividend has been rising roughly in-line with earnings.”

Potential positive: If the market remains risk averse, the company will be viewed to have very little downside in an economic downturn

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